Benjamin Franklin once said that the only things in this world that were certain were death and taxes. And while we cannot be certain that he was the first to record this observation, generally most of us would agree with him.
One item that seems fairly certain to occur sometime over the next 12 months or so is federal income tax reform legislation. While it is much too early in the process to discuss the details of any tax reform plan, there are a couple of items being discussed that, if passed, are certain to affect small businesses. These two items are the possible write off of all purchases except for land, and the non-deductibility of interest expense.
Current legislative proposals regarding business debt
Congress appears to be willing to offset the current year deduction for acquisitions of long-term assets with a disallowed interest expense deduction. While this may help to make the tax reform plan revenue-neutral, these expenses do not offset for the small business owner.
Currently, some asset purchases qualify for 100% expensing in the year of purchase while others qualify for 50% expensing. Other assets do not qualify for either, but instead qualify for depreciation over a period of time up to 39.5 years. During this time, businesses are allowed a deduction of the depreciation expense and the interest associated with any debt incurred on the purchase of the asset.
Over the life of the asset, the full cost of the asset is deducted by the business owner as depreciation. Plus, the full cost of financing the purchase of the building is also deducted. However, under current proposals, business owners would still deduct the full cost of a building purchase. But the business would not be able to deduct the cost of financing the building purchase, the loan interest. Interest on operating loans would not be deductible either.
As a small business owner, would the inability to deduct interest expense affect how you finance the operations and expansion of your business?
Tax reform is not the only reason to reduce business debt
Even if the latest tax reform proposals concerning purchases and interest expense do not become part of any final tax reform legislation, there are other good reasons to consider reducing or eliminating debt in your small business.
The cost of debt is certain to go up. The Federal Reserve raised interest rates twice over the last 14 months, increasing the fed funds rate from 0.25% to 0.75%. Most believe that interest rates will continue to go up. With increasing interest rates, the cost of financing major purchases will go up as well. Rates on business operating lines will also increase.
Debt reduces your flexibility. When that once-in-a-lifetime opportunity presents itself to your small business, will you be able to swiftly react? If you are carrying too much debt in your business, then the answer is probably no.
Debt causes you to make rash decisions. It’s funny how much more time business owners will spend making a business decision if they know they have to fund their decision with operating cash. Foregoing debt creates fiscal responsibility.
The decision to become debt free is the decision to pay more taxes
If you are thinking about becoming debt free, know this. There is only one way to significantly reduce your business debt. You must be more profitable. And that means paying more in income taxes. I often tell clients that paying off debt is similar to taking two steps forward and then one step back.
Generating additional profits is like taking two steps forward for your business. Paying the taxes on the profits is like taking one step back. After you have paid your taxes, then the remaining cash is yours. You can take it in distributions, you can spend it in your business, or you can pay off existing debt. Of these three options, which one is most likely to make your business more successful?
The Bottom Line
The road to no business debt is paved with good intentions. It sounds like a good idea. You know your business will be better off without the debt burden. But maybe the commitment is too much to consider right now. That’s fine. Set a long-term goal, and make progress every year. Make a commitment today to do something that you will thank yourself for in the future. And stick to it.
Need some inspiration? Read Debt-Free Dexterity, published in the February 2017 issue of Top Producer magazine, to learn how two business owners were able to get their businesses out of debt.